"As to Bonaparte, he was well assured that nothing remained for him but to choose between that hazardous enterprise and his certain ruin."
-Memoirs of Napoleon Bonaparte, by Bourrienne

Sunday, March 8, 2009

The root cause of the crisis

I have been trying to distill the most elemental cause of this great bust. There have been many things suggested such as: too easy monetary policy by the Fed, government intervention in the housing market, excessive greed by Wall Street, deregulation of financial markets etc.

Clearly, all of these things contributed. Most however are really cogs in the feedback machine. What is the root cause of it all?

Actually Alan Greenspan suggested what I think is the best explanation.

The US built up so much debt simply because it was cheap to borrow. Interest rates like all prices in a market economy are set by supply and demand. Now, its is true that central banks can manipulate certain rates in the short term. However most central banks claim to be targeting inflation. That means that they raise rates when they see inflation rising and cut rates when they see it ebbing which usually occurs when recession seems imminent. So in this view, central bankers don't really have much freedom. The best interest rate is the one that allows economic growth with low and stable inflation.

Long term interest rates are set in the market place and depend on the supply of loanable funds and the demand for loans. The interest rate is just the price where supply and demand meet. If inflation is high, fixed income investors demand a higher interest rate.

But inflation, at least the measure reported by the government, has been dropping even since the recession of the early 80s. The best explanation of why is probably the globalization phenomena and the cheap wages of developing countries like China and India. These countries provided cheap labor which resulted in cheaper priced goods which put an end to the wage-price spiral that dominated in the 1970s.

So when interest rates dropped, US debt doubled from 150% of GDP in the early 80s to nearly 300% now. Since the interest rate was lower, this large debt load was serviceable. For the household sector, debt service as percent of personal disposable income went from 11% to 14% which doesn't look as extreme as the total debt increase.

Now unfortunately this debt binge led to financial bubbles and the rest is history. However, the key economic feature is the disinflationary impact of the cheap labor from emerging markets providing a major source of global supply.

However, I think there is another economic phenomenon which gets much less notice. This is the rise of savings capital. The last 50 years has seen a huge increase in the percent of total assets held by institutions rather than individual. For example, pension funds, banks, insurance companies, central banks now hold the majority of the worlds financial assets. The decrease in inflation starting around 1980 accentuated this even further. The inflation which preceded it decimated the value of the fixed income investments held by these institutions. The disinflation which followed did the opposite. As interest rates fell, bonds rose in value. Stocks rose in value as well since 1982 marked a secular low point in the stock market. These institutions held many long dates bonds earning 15% interest rates or higher. These high rates were formerly offset by high rates of inflation but not these became excessively high real returns. The ultimate savers, institutions, got richer.

As these savings institutions got richer, they had more to invest and most had a mandate to invest mostly in fixed income investments. That is, they need to lend out their capital and they did. Low inflation and rising loanable funds, and low interest rates led to more debt for US households and businesses. The final bit was probably due to poor monetary policy as Greenspan juiced the market after the Tech crash, but the bigger debt bubble had been growing ever since inflation started to fall.

So in summary, the debt deflation that we are seeing now has its roots in the rise and fall of the Great Inflation of the 1970s combined with globalization of labor. Both of these pieces were needed and they are related since globalization is one of the things leading to lower inflation. If inflation did not moderate, interest rates would have stayed high and little new debt would have been take on. If there was no cheap foreign labor, the boom would have been arrested by rising wage inflation which would have led to higher interest rates.